Currency Trading Takes a Low-Volatility Holiday

As record low volatility in the foreign exchange market has
driven traders away, global currency-trading volume is
slipping. Marc Chandler, global head of currency strategy for
New Yorkheadquartered private bank Brown Brothers
Harriman, has experienced the decline firsthand. The bank
gives me some money to trade, but this year Im hardly
trading, he says.

This bad news from financial institutions
currency-trading departments, which need volume and volatility
to make money, augurs poorly for short-term speculators. But
its good news for multinational corporations and
long-term international investors, which will have less need to
hedge their currency exposure. In any case, market participants
expect volume and volatility ultimately to return, as more
players and currencies enter the market.

Low volume tends to beget low volume, says
Robert Sinche, global strategist for broker-dealer Pierpont
Securities in Stamford, Connecticut. A lot of the
short-term volume would normally come from the active investing
community, like hedge funds. But the abundant credit means less
participation in markets and smaller speculative
positions. That drop in trading volume is
self-reinforcing. Short-term speculators are getting driven out
of the market, says Sinche. Several major currency hedge funds
 including FX Concepts, once the worlds largest
 closed shop over the past year.

Macro funds havent had much to work with since
2013, when shorting the yen was a winning trade, says
David Gilmore, a partner and economist at Foreign Exchange
Analytics, a currency research firm in Westbrook,
Connecticut.

Meanwhile, banks are cutting their trading operations as
regulation limits speculative activity. For example, the
Volcker Rule of the 2010 DoddFrank Wall Street Reform and
Consumer Protection Act restricts banks ability to take
proprietary currency positions. Capital to run trading
operations is being put to use elsewhere, where there is more
income, Gilmore says. Regulators want to shut down
the casino element of the marketplace.

To some extent, the drop in currency-trading volume simply
reflects the shrinkage of an overgrown financial sector.
The financial sector is still too large relative to the
economy its meant to support, so reversion to that mean
will affect more than just currency volume, Gilmore says.
Fixed income and commodities are in the same
predicament.

Some in the financial world stand to benefit from the slow
times in currency trading, however. Thanks to the drop in
volatility, multinational corporations and long-term investors
dont have to worry so much about hedging their currency
exposure.

Its not necessarily a bad thing, Sinche
says. The real investment world can focus on the
underlying investment.

Is this the new normal or just a phase? Chandler, Gilmore
and Sinche agree that currency-trading volume will remain
sluggish until central banks monetary policies begin to
diverge. Many economists expect the Bank of England to begin
raising interest rates in the first quarter of 2015, and the
Federal Reserve to follow suit in the second or third
quarter.

Maybe in the middle of next year, volume will increase
again, Chandler says. He doesnt think weve
seen the peak of currency turnover yet. But I suspect the
drivers of trading volume will change, he continues.
When I started in the business in the mid-1980s, banks
were dominant. But now theres a rise of retail and high
frequency trading. As an example of retail trading, he
cites the growth of currency-focused
exchange-traded funds.

In addition, despite the loss of many European currencies
with the 1999 introduction of the euro, plenty of currencies
are becoming tradable in emerging markets, frontier markets and
markets that are even smaller still. Currencies that
cant be traded now, will be, over time, says
Chandler. Economies will mature and adopt better
practices.